A funny thing is going on in the markets, on the one hand you had US equity markets make fresh record highs earlier this week, on the other hand bond yields have fallen sharply. The U.S. 10-Year is hovering close to 2.5%, the lowest level since October, and yields have been falling along the curve.
When the bond market starts to do something different from other markets it is worth taking note. Traditionally bond investors tend to be long-term investors who trade on macro themes. Due to this, it gives the bond market a certain credibility that other asset classes like equities, with a large proportion of short term investors, do not share.
Watch the yield curve
This theme is gaining traction because the US yield curve has started to fall, or invert. This happens when longer-dated yields start to fall at a faster pace than short-dated yields. Take a look at the chart below, which shows U.S. 10-Year – U.S. 2-Year. As you can see, since the start of this year the trend has been lower, as 10-year yields fall at a faster pace than short-dated yields, even though they are nominally higher.
This is worrying, since an inverted yield curve is normally a precursor of a recession. The yield curve is telling us that the Treasury market does not believe that the recovery will be strong this year, after Q1 GDP rose a measly 0.1%.
The inverted yield curve could serve as a wake-up call to equity investors; after all, how can record highs in the S&P 500 and the Dow Jones be justified when growth is weak?
However, there is a case to be made that bond investors are overly pessimistic. For example, the US created nearly 300k jobs last month and initial jobless claims fell below 300k for the first time since 2006, yet this has not halted the slide in yields.
With GDP expected to rebound in Q2, are bond investors cherry-picking data to suit their bearish argument, and could Treasuries be over-priced at this juncture?
It seems to me that the real health of the US economy lies somewhere in between the exuberance of the equity market and the pessimism of the bond market, which increases the prospect of a correction across asset markets.
The market impact:
Right now, it seems that the equity market is catching up with the bond market, which could hurt stocks in the near-term. With fresh record highs for US markets earlier this week, a bout of profit taking at this stage is not unusual.
However, going forward, the uptrend in stocks may not be over, as it could take a serious deterioration in US data, or a major flare up of the geopolitical tensions between Russia and Ukraine to push yields below their current levels.
Thus, it could be harder to justify a deeper inversion of the yield curve from here.
The bond market is also impacting FX. Two factors could be propping up the Dollar, which has risen to its highest level in a month.
Firstly, the dollar may be acting as a safe haven, and rallying in line with bonds, which typically experience buying pressure when investors get nervous.
Secondly, when demand for Treasuries is high (pushing yields lower) this can drive in-flows into the greenback. If the greenback is moving in line with Treasuries, then we may see further upside as long as yields start to fall.
An alternative view:
Another way of looking at the inflows into Treasuries is that investors are hedging their positions in equities. The VIX, Wall Street’s fear gauge, sunk to extreme lows earlier this week, which helped stocks to rally to record highs.
However, if we have learned one thing in the last 6 years it is that volatility doesn’t stay low forever. Back in 2007/08 volatility was extremely low, before it exploded with the onset of the financial crisis, causing a surge in demand for Treasuries and stocks to fall off a cliff.
Although there is no immediate crisis in view, investors may be trying to second guess what happens next, believing that the good times cannot go on forever. Whether this becomes a self-fulfilling prophesy, we shall have to see. For now, investors are booking profits and staying away from risk.
Takeaway:
• Yields are falling across the curve.
• Longer-dated yields are falling at a faster pace than short-dated yields, which can signal a recession.
• Investor pessimism in the bond market has not been mirrored in equity markets, although stocks are starting to sell off on Thursday.
• This suggests that “risk of” is dominating markets right now, which could boost the dollar in the near-term.
Figure 1:
Source: Bloomberg and FOREX.com